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The end of inflation?

Asset prices have sky-rocketed over the past decade, but retail price inflation is muted. Meanwhile, the monetary environment is as loose as it has ever been. Is this truly the end of inflation? We look the economics and put startup investing in the context of the global macro economy.

The longest bullmarket

On the 2nd of September, the S&P 500 peaked at 3,580. By then it had staged a remarkable rally since the CARES Act was enacted into US law on the 27th of March earlier this year.

The CARES Act followed a round of quantitative easing announced by the the Federal Reserve on March 15. This included purchases of $500 billion in U.S. treasuries and $200bn in mortgage backed securities

This year’s rally is itself an extension of a much longer bull market which started in 2009. Following the financial crisis, the American Recovery and Reinvestment (ARRA) Act was passed to breathe some fiscal stimulus into the economy. This fiscal stimulus also came on the back of the first quantitative easing (QE) programme, announced by the fed in November 2008.

The combination of QE and the 2009 ARRA stimulus kicked off the longest bull market in history.

Since March 9th, 2009 and September 2nd 2020, the SP500 index grew from 676.53 to 3,580. This means a 5-fold in a little over a decade. Quite extraordinary.

So it seems that twice in the same economic cycle, growth in asset prices have been kick-started by significant fiscal programmes backed by quantitative easing. And due to QE, it has been easy for governments to fund the fiscal stimulus. Essentially, the fed and other central banks have purchased whatever debts governments wanted to issue, keeping interest rates ultra-low.

Although asset prices (like the SP500) have skyrocketed, Governments have been able to run fiscal deficits without causing any meaningful retail inflation. Indeed, Fed Chair Jerome Powell specifically said that he was not concerned about the increase to the Fed’s balance sheet because inflation isn’t currently and issue.

But doesn’t this seem to run counter to traditional fiscal patterns? Let’s take a brief trip back in history.

The “good old days”

The asset price inflation of the 1920s gave way to the great depression and economic collapse. The extent of the depression was perhaps made more so by US President Herbert Hoover’s policies. His Treasury Secretary Andrew Mellon sought to use the crisis as an opportunity to “Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate” in order to clear up the financial system.

As a response to the general economic malaise of the 30s, John Maynard Keynes wrote his hallmark book ‘The General Theory of Employment, Interest and Money’ in 1936. He argued that rather than using crisis as an opportunity to liquidate everything, the government should use crises as an opportunity invest aggressively, so as to create demand when markets slump.

Keynes’ policies forged the basis of the post-war consensus, more or less, until the oil shock of the 1970’s. At that point, it seemed that fiscal expansion started to simply lead to higher inflation and stubbornly high unemployment (stagflation).

Enter Milton Friedman and the monetarist economists who had a strong focus on managing inflation by managing money supply in the economy.

Managing inflation became the new economic mantra up through the 80s, and reserve banks across the developed world were very successful at bringing down the rate of inflation.

And as inflation came down, interests came down, and asset prices started to grow.

Then things started to get really interesting.

Back to “the present”

In the past 12 years, we have twice seen crises followed by big economic stimuli. Both times, these have happened without either interest rates or inflation taking off.

Government have been able to run large deficits without increase in interest rates due to QE. As governments have needed to borrow more, central banks have just expanded their balance sheets to buy the new government debt. Government have been funded and interest rates stayed low. Presto!

And inflation? Where did that go? Didn’t it use to be that running large government deficits would push demand up in the economy. And that this would lead to both retail price and wage inflation?

Enter another actor – globalisation.

Globalisation – an “infinite” labour pool

Government fiscal stimulus used to put pressure on local supply chains (especially labour) and this could simultaneously push down unemployment and push up inflation. However, the globalisation we’ve seen since the 1980s have meant that the wider impact on demand have happened not just in the national economies, but globally. A few years ago, Branko Milanovic and Christoph Lakner (formerly of the World Bank) showed how most of the world had seen significant income growth from globalisation, except for the lowest earners in countries such as the US and the UK. While these groups might historically have benefited from economic stimulus (due to more local jobs in e.g. manufacturing), many of these jobs have now gone overseas. This boosted the incomes of workers in e.g. China, but leaving workers in developed economies short-changed – sometimes even with negative income growth.

There are several implications of this. Some of them are political, and we have seen how trade and immigration have become more dominant in the political debates. But there is also an economical implication, which is that we have more elasticity in the labour market. This in turn means that it has been possible for governments to run big deficits for a sustained period of time without worrying about inflation (as per Jerome Powell’s analysis). The effect of globalisation is not likely to disappear immediately, and we are likely to see a continuation of low interest rates and a relaxed monetary environment for a period of time to come. The question is, what follows that?

The age of disorder

In a recent analysis, Deutsche Bank talked about the coming decade as the Age of Disorder. The DB analyst team highlights brewing US / China tensions are likely to lead to some reversal of globalisation. This – in turn – could lead to higher overall import prices that will have both first and second order impact on inflation:

  1. Prices of imported goods are higher (–> inflation), and
  2. Local production will become more cost competitive, which could push up local labour demand, wages and therefore costs (–> inflation).

So in many ways, the big economic experiments begun in the late 70s and early 80s (globalisation + inflation management and low interest rates) enabled the type of quantitative easing we have seen from 2008. And all of this has now led us to quite a unique position. If a reversal of globalisation leads to more inflation, this could make QE and fiscal deficits more difficult to manage in the future. This could in turn suggests that we might be in for some asset price turbulence in the medium term, as both national economies and the global trading system looks to reshape itself to the changing political pressures

What are the implications for start-up investing?

At SuperSeed we invest in startups that make technology for business automation. That is essentially a way for companies to use software and associated technologies (such as Internet of Things) to produce their goods and services more cheaply. While it is likely that there will be pressure on many industries and perhaps even overall asset prices in the years ahead, we continue to see a strong opportunity in startups that help businesses be more efficient. Especially in an environment where easy gains from labour arbitrage (“off-shoring”) start to wane, the focus only likely to intensify on technologies that can help companies manage costs in an uncertain economic environment. The start-ups we investment in develop exactly such technologies, which is why we see such a good opportunity in the decade ahead.

This article is published by SuperSeed Ventures LLP which is authorised and regulated by the Financial Conduct Authority. The article does not constitute substantive research or analysis, and should not be construed as an investment recommendation in relation to any publicly traded company. Please note, investments in unlisted early stage companies are illiquid and expose investors to a significant risk of losing all money invested. Please always seek independent financial advice before making investment decisions.